Sri Lanka’s commitment to fiscal consolidation faces downside implementation

Moody’s Investors Service says that Sri Lanka’s (B1 negative) program with the International Monetary Fund (IMF) has helped stabilize the balance of payments and established an ambitious roadmap to fiscal consolidation and structural reform. However, sustained implementation of reforms will be challenging.

The 2017 budget confirms the government’s strong commitment to fiscal consolidation with a number of measures identified to improve tax revenues.

Given Sri Lanka’s weak fiscal position and need for growth-enhancing public expenditure on infrastructure and development programs, plans to increase government revenues will play an important role in bolstering debt sustainability and the overall sovereign credit profile. Revenue mobilization efforts will likewise be key to creating fiscal space for increased spending and deficit reduction, while tempering external vulnerabilities. After the VAT rate increase in 2016, the 2017 budget focuses in particular on raising corporate and individual income tax revenues through a simplification of the tax structure.

However, if effective, significant fiscal tightening and higher inflation in response to the VAT rate hike will dampen growth. This will limit the revenue dividends of fiscal reforms for the government, at least in the short term. The toll on households and corporates’ net incomes will make sustaining tight fiscal and monetary policy for several years increasingly challenging.

Moreover, the government’s projections for higher revenues rely on ambitious assumptions about real GDP growth and about the effectiveness of the restructuring of income tax and new electronic tax collection system. If economic activity disappoints or tax-raising measures yield lower outcomes than currently budgeted, the fiscal targets may slip. One option would be to cut back on public investment expenditure to meet its targets, but such a scenario would weigh on GDP growth. In turn, fiscal slippage and/or weakening growth could undermine foreign investors’ confidence in the ability of the authorities to reduce Sri Lanka long-standing macroeconomic imbalances.

Moody’s analysis is contained in its just-released report titled “Government of Sri Lanka: Effective Revenue Reforms Remain Key to Credit Outlook”.

Moody’s report says that Sri Lanka’s robust growth potential, as well as its relatively large economy and higher income levels when compared with similarly rated sovereigns, support its B1 rating. However, at 76.0% of GDP in 2015, the government debt burden is well above the B-rated median of about 50% and has climbed rapidly from a recent trough of 68.7% in 2012.

Moody’s explains that the Sri Lankan government’s 2017 budget proposal is broadly consistent with its fiscal consolidation roadmap with the IMF, and illustrates its commitment to the program. The administration is relying on significant increases in tax revenues to drive budgetary consolidation, and bases its projections on a mixture of implemented and planned measures.

Moody’s says that unless capital inflows increase markedly and stay at a higher level, foreign exchange reserves will remain low in relation to imports and external debt payment needs. The value of foreign exchange reserves (excluding gold and SDRs) fell to $4.73 billion in November 2016 from $5.07 billion in October 2016, and a most recent peak of $5.59 billion in August 2016. (Moodys)

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